Definition of QE2

Quantitative easing (QE) is the practice of expanding a central bank’s balance sheet by buying long-term assets in an attempt to drive down long-term interest rates, something that it only has reason to do once short-term interest rates are already at or close to zero.

In 2010, the Federal Reserve launched a new programme of quantitative easing - nicknamed QE2 - and will buy $600bn of longer-term Treasury securities by the middle of 2011. It has done so because America’s economic recovery has been a disappointment, weighed down by debts backed by houses that have fallen in value. Households are reluctant to spend, so businesses are reluctant to invest.

Since April 2010, the US private sector has struggled to create 50,000 jobs a month, that is barely enough to keep up with population growth, let alone bring down the 9.6% unemployment rate. The Congressional Budget Office estimates that the output gap - the difference between what the economy could produce and what it actually did - was 6.3 per cent in the second quarter of 2010.

On the other side of the ledger – inflation – the Fed’s preferred price index for core personal consumption expenditures is up by only 1.5 per cent on a year ago and that compares to the Fed’s objective of 2% and may fall further in the coming months.

Political deadlock means that there is little chance of any further fiscal stimulus, so the Fed is the only agency in town with any hope of getting the economy going, and driving down long-term interest rates with QE2 could be its best bet.

In QE2, the Fed will expand its balance sheet through purchases of long-term Treasury bonds.

The Fed and its chairman, Ben Bernanke, believe that QE works by changing the balance of risks on offer to the private sector. By buying large numbers of risk-free long-term Treasury bonds, they think they can force the public either to pay more for similar bonds or to invest in something else.

That something else might be a loan to a company, which would in turn use the funds to invest and so boost the economy

Market reactions, since Bernanke gave a big speech to central bankers in Jackson Hole, Wyoming, on August 27, have been an encouraging sign that QE2 may work. The spread between yields on regular 10-year Treasury bonds and on inflation-protected 10-year Treasury bonds which gives a sign on how much inflation the market expects have risen from 1.6 to 2.1 percentage points. In addition, the trade-weighted dollar has fallen by more than 4 per cent. These moves show markets believe QE2 is capable of moving asset prices, at least. Although, there is still a question about how much that can spur the economy.

For a hard core of hawks on the Federal Open Market Committee (FOMC), the risks of failure with QE2 are so grave that the policy ought to be ruled out altogether. QE2 is often described as ”printing money”, although a better description is "forcing loans on people who are reluctant to spend them", and the obvious risk is that the Fed could go too far and thus ignite inflation.

But the more serious risk is that by pushing down yields on long-term US Treasury bonds - the world’s benchmark interest rate - the Fed will be forcing investors into other assets, from foreign currencies to equities. That may have unintended consequences, not least the risk of creating asset price bubbles, which may end unhappily. [1]